Eric Mancini: As I mentioned in our November interview, at Traphagen Financial Group, we manage fully diversified stock, bond, and alternative client portfolios with an intense focus on risk management and how best to allocate among all investable asset classes. We look for value in overlooked areas of the market and discarded individual stocks which can produce superior risk-adjusted returns. We always place safety of principal first and foremost and accept unsystematic risk only when we feel there’s a corresponding probability of outsized investment returns.

Today, I’d like to discuss a couple different areas that our firm has been researching and implementing for our clients over the past five months. We’ve been putting emphasis on identifying alternative sources of meaningful investment returns. This focus has been spurred on by recent run-ups in most traditional asset classes.

These recent increases in asset prices indicate to us that future returns on most of these traditional investments could be fairly muted over the coming years. Obviously, bond returns will be lower than in the past 30 years with a 10-year treasury yielding 1.7%, investment grade bonds yielding around 3%, and publically traded real estate, or REITs, yielding a little over 3%. In addition we feel commodities and equities are currently priced to deliver returns in the mid-single digits over the next several years. These all represent modest returns when compared to the past 30 to 40 years.

Wally Forbes: So where does that lead you?

Mancini: It leads us into very unique and hard to access areas of the markets. And that’s where we’ve been doing the majority of our research and allocation of client funds over the past 2 quarters. Basically, there are two alternative areas that I’d like to discuss today in more detail. The first are reinsurance-related investments that come in two flavors; catastrophe bonds and what is called ‘quota share’.

Catastrophe bonds are credits issued by reinsurance companies that are related to natural disasters and weather events. They are essentially selling risk off their books, and we, as investors, are assuming that risk in exchange for an investment return. The aspects we like about this investment are many. First, the majority of these bonds yield 6% to 8% above the short-term treasury rate, and they do float, so if interest rates rise, we benefit from that with higher paid rates. There is essentially no credit risk with these since the capital for the bonds are placed in a special purpose entity backed by U.S. treasuries. In addition, the return on the bonds is not correlated to any other financial asset; the only variable that affects the return is the severity of weather events and natural disasters across the globe.

The second area we are looking at within the reinsurance market is called ‘quota share’. This is actually a slice of a diversified insurance company’s risk portfolio. The major reinsurance company we utilize insures against a wide array of perils, including air travel risks, terrorism, weather events, artwork theft, et cetera. And we, as investors, purchase a portion of their risk portfolio. This is a little higher-risk but higher-return investment. But again, like the catastrophe bonds, completely non-correlated to any other financial asset class and should, over the longer term, produce significant returns.

Forbes: When you buy the risk portfolio, are you essentially taking on the insurance?

Mancini: Yes, we are in the same position as the insurance company. They insure, collect the premiums, and we’re taking the same exact risk as them.

The other alternative strategy is really trying to take advantage of investor psychology and what’s called the ‘variance risk premium’. For those who are unfamiliar, the variance risk premium is the investment return one expects by exchanging certainty for uncertainty; and in our case we will be doing this via the options market. We will be strategically selling options across the stock market and on individual stocks depending on market volatility and option pricing.

Simply stated, when the markets are doing very well and volatility is low, investors take long shot bets — basically buying lottery tickets. In reality, this means they are buying short-dated call options on individual stocks. This strategy systematically sells these overvalued call options and collects the premiums. Conversely, when the market is highly volatile and investors are scared, they tend to purchase overpriced insurance, namely put options. And again, the strategy is to systematically sell these overpriced index put options and collect the premiums. At the same time, the fund has exposure to the Russell 1000 Index, and should capture the variance risk premium on top of the stock index return.

Another important point and benefit of this strategy is the overall volatility should be approximately 30% lower versus just holding the stock index. And with all the option premiums brought in, the investment should yield about 5% to 6% annually.

Forbes: So you don’t do any direct investing in stocks or securities, per se. You’re doing it all by these bundles. Is that correct?

Mancini: We do hold the index underneath, but a lot of the return, risk reduction, and yield is generated by the systematic selling of options. So as traditional asset class future returns diminish, these two strategies should provide pretty significant and uncorrelated returns for our clients.

In addition, we’re always looking for undervalued stocks that add risk adjusted returns to client portfolios. I do have three stocks I’d like to discuss briefly with you, but first wanted to remind your readers that we use a discounted cash flow model as a basis for our analysis. The model makes very conservative assumptions for sustainable free cash flow and future growth rates to value these stocks. This ignores stated earnings and digs into the accounting to find operational free cash flow minus capital expenditures, adjusted for cyclicality. This, in our opinion, is the best measure of long-term wealth available to shareholders. And, as we discussed before, we also rarely assume future free cash flow growth of more than 2% to 3% per year.

Forbes: Value oriented, shall we say?

Mancini: Very much so. Yes, we’re quite conservative when it comes to valuing and purchasing individual stocks. That being said, the first stock we are watching is Quest Diagnostics Quest Diagnostics. It’s a leader in diagnostic testing, information, and services.

Obviously, it’s positioned to take advantage of the demographic tailwinds here for decades to come. And we do think, on balance, ObamaCare will be a net positive for the company with more and more people insured and getting more precautionary testing done. Since 2004, free cash flow has increased from $2.90 per share to $6.30 per share, which is impressive. In addition, the shares outstanding decreased from 214 million to 160 million over that same timeframe.

The company yields around 2% and they have continually bought back shares. If we assume a conservative free cash flow, growth rate of 2% to 3% per year we get a fair value for the stock in the mid-50s, which is where the stock is currently trading. So on any weakness we would be buyers at about the $50 level.